Mortgage-Backeds Finally See a Rally

Last week got off to a roller-coaster ride in the first two days of trading following the long holiday weekend. Monday experienced a strong flight-to-quality bid prompted in part by concerns regarding the GSEs.

Contributing to this was a report from Lehman Brothers discussing an amendment to FAS 140 that would require certain off-balance-sheet items to be consolidated onto the balance sheet. This could require Fannie Mae and Freddie Mac to raise substantial amounts of capital, said Lehman analysts, although they believe the GSEs would get some sort of exemption or modified capital requirements, as "severely undercapitalized GSEs could possibly topple the already fragile capital markets."

On Tuesday, most markets rallied in response to a number of factors, including comments from Federal Reserve Chairman Ben Bernanke about potentially extending the emergency lending facilities to primary dealers into next year if necessary. Adding to the commotion were remarks from Office of Federal Housing Enterprise Oversight Director James Lockhart that changes in accounting rules would not necessarily lead to requiring the GSEs to increase their capital. There was also the more than $5 decline in oil prices as a response to Iran's leader dismissing the idea of war against the U.S. and Israel, as well as a speech by Treasury Secretary Henry Paulson outlining a plan to help the housing market.

Mortgages opened the week wider with little buying interest, although there was notable servicer selling. By noon, with the flight-to-quality trade gaining strength, spreads had widened to around 20 ticks on 5s and 13 ticks on current coupons. This brought out active buying both outright and versus Treasurys and swaps from hedge funds, and money managers focused primarily in 5s through 6s. Spreads still closed weaker but substantially off their wides of the day.

Tuesday saw massive buying attributed to the dramatic MBS cheapening this month as well as the various headlines regarding government support for various components of the housing market. Just about every investor was buying - real money, leveraged, money market, hedge funds, banks - with interest along the entire coupon stack.

Strong interest continued into Wednesday's session with MBS prices several ticks higher while Treasurys were slightly lower over the day, with some profit taking emerging periodically from both domestic and overseas investors.

Month-to-date through July 8, Lehman's MBS Index was underperforming Treasurys by 76 basis points and lagging competing sectors as well. The ABS Index was down 19 basis points, CMBS was lagging by seven basis points and U.S. credit was negative 32 basis points.

Anxiety and stress levels remain high in the market, and this will keep investors very sensitive to profit-taking opportunities. Spreads are deemed attractive, but risks regarding earnings, regional financial institutions, the GSEs, continuing balance sheet constraints and liquidity issues are keeping investors cautious.

Mortgage Applications Gain

Mortgage application activity was modestly higher in the holiday-shortened week ending July 4. The Mortgage Bankers Association (MBA) reported that the Refinance Index rose an adjusted 8.7% to 1379.3 and the Purchase Index increased 6.7% to 365.8. The MBA also noted that the Conventional Purchase Index was up just 1.6%, while the Government Index jumped 19.8%.

The increase came despite higher mortgage rates. The MBA reported a 10-basis-point increase in the 30-year fixed and one-year ARM contract rates to 6.43% and 7.24%, respectively.

As a percent of total applications, refinancing share was 37.3% compared with 36.8% in the previous report. ARM share was also higher at 10% versus 8.5%.

Another Slower-than-Expected Prepay Report

June CPRs were slower than the negative 3% to negative 4% that was expected. Instead, speeds declined 10% on average for Fannie Mae, 13% for Freddie Mac and 8% for Ginnie Mae securities.

Speeds on conventional 5.5s and higher, in particular, recorded the greatest percentage declines, averaging 10% to 15% slower on FNMAs (15% to 20% on FHLMC Golds ) versus expectations of negative 4% to negative 7%.

For GNMAs, 2007 vintages experienced the largest percentage decline at 24% on average, with 2006 vintages slowing 10% on average.

The MBA Refinance Index averaged just 2036 in May, down 15.6% from April's average. In addition, higher delivery fees associated with a borrower's LTV and FICO that became effective on June 1 are also seen as contributing factors to the slowing, Lehman Brothers analysts said.

eMBS reported that the aggregate CPR on 30-year FNMAs was 9.2 CPR compared with 10.5 in May, a decline of 12.4%. The drop in FHLMC Golds was 9.3 CPR versus 11.0 CPR previously, down 15.5%, and GNMA's prepaid at 10.7 CPR, an 18% decline from the 13.1 CPR recorded in May. Total agency MBS paydowns were $43.9 billion, down from $46.2 billion in May, and issuance was $106.8 billion versus $119.1 billion.

For the July prepayment report, further slowing in speeds is expected. On average, 30-year fixed mortgage rates averaged 6.32% in June compared with 6.03% in May, and the Refinance Index was down 33% from May's average. A higher day count - 22 versus 21 days - provides a slight offset.